Earnings management in initial public offerings (IPOs) of u s REITs

EARNINGS MANAGEMENT IN INITIAL
PUBLIC OFFERINGS (IPOS) OF U.S. REITS

SHEN HUAISHENG
(BACHELOR OF MANAGEMENT, ZHEJIANG UNIVERSITY)

A THESIS SUBMITTED
FOR THE DEGREE OF MASTER OF SCIENCE
DEPARTMENT OF REAL ESTATE
NATIONAL UNIVERSITY OF SINGAPORE
2008


Acknowledgements

I would like to express my deepest gratitude to all those who make this thesis
possible, and help me through out the whole master program.

First, I am deeply grateful to my advisor and friend — A/P Sing Tien Foo. His
insightful ideas, patience and support has been a great fortune for me.

Next, I wish to express my sincere thanks to A/P Fu Yuming, Prof. Ong Seow
Eng, and A/P Tu Yong who helped my throughout my course work and research
in various ways.

I am really appreciated for members of SDE family who provided favorable environment for me. And my thanks goes to Mr. Zhu Yuanwei, Mr. Zhou Sheng, Mr.
Wu Jianfeng, Mr. Wang Jinliang, Mr. Sun Liang, Mr. Chen Zhiwei, Ms. Xu
Yiqin, Ms. Liu Bo, Ms. Tan Yan Fen, Ms. Xie Yajun, and Ms. Li Mu.

My thanks also goes out to the Department of Real Estate, National University of

ii


Acknowledgements

iii

Singapore.

Above all, I am gratitude for support of my parents and my brother. And for
whom I dedicate this thesis.

Shen Huaisheng
Aug 2008


Contents

Acknowledgements

ii

List of Tables

v

List of Figures

vi

1 Introduction

1

1.1

Research Questions . . . . . . . . . . . . . . . . . . . . . . . . . . .

1

1.2

Motivation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1

1.3

Significance of the Study . . . . . . . . . . . . . . . . . . . . . . . .

3

1.4

Hypothesis Development . . . . . . . . . . . . . . . . . . . . . . . .

4

1.5

Organization of the Study . . . . . . . . . . . . . . . . . . . . . . .

6

2 Literature Review
2.1

7

IPO Underpricing . . . . . . . . . . . . . . . . . . . . . . . . . . . .

7

2.1.1

9

Information Asymmetry . . . . . . . . . . . . . . . . . . . .

iv


Contents
2.1.2

v
Behavioral Theories . . . . . . . . . . . . . . . . . . . . . . .

15

2.2

Earnings management . . . . . . . . . . . . . . . . . . . . . . . . .

18

2.3

Economies of Scale . . . . . . . . . . . . . . . . . . . . . . . . . . .

20

2.4

REIT IPOs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

24

3 Empirical Methodology
3.1

3.2

28

Measurement of Earnings Management . . . . . . . . . . . . . . . .

28

3.1.1

. . . . . . . . .

30

Economies of Scale Measures . . . . . . . . . . . . . . . . . . . . . .

33

3.2.1

Translog Model . . . . . . . . . . . . . . . . . . . . . . . . .

35

3.2.2

Simple Quadratic Model . . . . . . . . . . . . . . . . . . . .

35

3.2.3

Quadratic Semi-Log Model . . . . . . . . . . . . . . . . . . .

36

Earnings Management Measurement Model

4 Empirical Findings

37

4.1

Data Source . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

37

4.2

Earnings Management . . . . . . . . . . . . . . . . . . . . . . . . .

38

4.2.1

Earnings Performance . . . . . . . . . . . . . . . . . . . . .

38

4.2.2

Accrual . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

48

4.2.3

Regression analyses of Explanatory power of Discretionary

Current Accrual

. . . . . . . . . . . . . . . . . . . . . . . .

58

4.2.4

Potential Sources of Earnings Management

. . . . . . . . .

59

4.2.5

Robustness Test . . . . . . . . . . . . . . . . . . . . . . . . .

70

5 Conclusion

80

5.1

Major Findings . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

80

5.2

Limitations of the Study . . . . . . . . . . . . . . . . . . . . . . . .

82


Contents
5.3

Future Studies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Bibliography

vi
83
84


List of Tables

3.1

Definition of Variables Used in the Modified Jones Model . . . . . .

31

4.1

Summary of Property Type . . . . . . . . . . . . . . . . . . . . . .

40

4.2

Characteristics of IPO firms ($ millions) . . . . . . . . . . . . . . .

41

4.3

Industrial Adjusted Return On Asset (ROA) . . . . . . . . . . . . .

44

4.4

Industrial Adjusted Operational Cash Flow to Total Asset Ratio . .

45

4.5

Modified Jones’ Model . . . . . . . . . . . . . . . . . . . . . . . . .

51

4.6

Discretionary Current Accrual with Modified Jones Model on Revenue 55

4.7

Discretionary Current Accrual with Modified Jones Model on Cost .

56

4.8

Characteristics of Aggressive and Conservative REITs . . . . . . . .

57

4.9

Explanatory Power of Discretionary Current Accrual on Earning
Performance Changes . . . . . . . . . . . . . . . . . . . . . . . . . .

60

4.10 Explanatory Power of Discretionary Current Accrual on Price Changes 61
4.11 Unexpected Account Receivables . . . . . . . . . . . . . . . . . . .

64

4.12 Unexpected Account Payables . . . . . . . . . . . . . . . . . . . . .

65

vii

List of Tables

viii

4.13 Explanatory Power of Discretionary on Change on Depreciation . .

69

4.14 Discretionary Current Accrual of Pure-REITs . . . . . . . . . . . .

71

4.15 Earnings Management Before and After Sarbanes-Oxley Act . . . .

72

4.16 Translog Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

74

4.17 Simple Quadratic Model . . . . . . . . . . . . . . . . . . . . . . . .

75

4.18 Quadratic Semi-Log Model . . . . . . . . . . . . . . . . . . . . . . .

76

4.19 Average Economies of Scale Estimate (SCE) . . . . . . . . . . . . .

79


List of Figures

4.1

Number of IPOs . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

39

4.2

Net Income and FFO Scale on Total Asset . . . . . . . . . . . . . .

43

4.3

Total Asset by year . . . . . . . . . . . . . . . . . . . . . . . . . . .

47

4.4

Total Asset by years after IPO . . . . . . . . . . . . . . . . . . . . .

48

4.5

Marginal Effect of FFO over years after IPO . . . . . . . . . . . . .

49

4.6

Yearly Average Age of REITs in the Market . . . . . . . . . . . . .

50

4.7

Depreciation proxy by (F F O − N I) . . . . . . . . . . . . . . . . . .

68

ix


Chapter

1

Introduction
1.1

Research Questions

This thesis focuses on earnings management in REIT IPOs. We attempt to test
whether REIT IPOs involve in the earnings management. If they do, what is the
impact of the earnings management on the post-IPO period performance of the
stocks.

1.2

Motivation

Ritter and Welch (2002) documented that from 1980 to 2001 Initial Public Offerings
(IPOs) industrial firms reported an average 18.8% abnormal initial return at the
end of the first day of trading. However, Ritter (1991), in a separate study, found
that the cumulative adjusted returns (CAR) of a sample of 1526 industrial company
IPOs in 1975–84 fell by 29.13% after 36 months. For REITs, the empirical evidence
is mixed. Wang, Chan, and Gau (1992) found that REIT IPOs had a negative

1


1.2 Motivation
initial trading return of 2.82%, but they under-performed in the 190 trading days
after IPO date. In contrast, Ling and Ryngaert (1997) found that in the period
1991-1994 REIT IPOs had a moderate positive initial return of 3.6%, and outperform comparable Seasonal Equity Offering (SEO) REITs in 100 trading days
after IPOs. Besides the two contrasting findings, Buttimer, Hyland, and Sanders
(2005) found that that REIT IPOs had a smaller initial return, but they neither
under- nor out-perform in the following IPO days.
Despite the variations in the returns on initial abnormal returns and after-market
performance of REIT IPO, the early studies implicitly assume that REIT companies’ financial statements, especially earnings, accurately reflect their intrinsic
value.

To maintain their tax-exempt status, REITs invest primary in real estate and
cannot expand their investment freely to other asset classes. They are required to
distribute 90% of their net income to shareholders as dividends. These requirements allow REITs to operate in a simple business structure, which could be easily
understood by potential investors. The REIT model is also more transparent,
which allows investors to make better informed investment decisions. With less
free cash flow available, REIT managers are supposedly constrained in the ability
to manipulate cash flows to the detriment of potential investors. Therefore, REITs
are considered to be less susceptible to agency problems compared to after listed
firms in other industries.
However, does the relative transparent of REIT model necessary better insulate
to investors against undesirable agency problems? Even though REITs are more
transparent after they have been listed on the exchanges, they are less known to

2


1.2 Motivation
investors before IPO. Rao (1993) reported that there was almost no media coverage
of firms in the year before the IPO. The lack of information forces investors to rely
solely on the firm prospectus, which may contain only the financial statements of
the past 1 to 3 years. Investors may even under-utilize information in financial
statements in their decision making process (Ou and Penman (1989) and Sloan
(1996)).
If we assume that investors are unable to fully understand the extent of earnings
management in either the past or the future earnings that IPO firms engage in,
higher reported earnings can be directly translated into higher offer price. The accrual accounting principle in the financial reporting system does not prevent firms
making earnings management to inflate firm returns prior to IPO.

Teoh, Wong, and Rao (1998) found that IPO companies are opportunistic. The

quartile of IPO firms that manage their earnings more aggressively, have a threeyear post-IPO stock returns of approximately 20% less than the more conservative
counterparts (Teoh, Welch, and Wong (1998)).
However, if firms face diminishing economies of scale, the deteriorated stock
returns in post-IPO periods may be partly caused by scale effects, instead of solely
by earnings management. Therefore, it is necessary to test both the earnings
management and the economies of scale for REIT IPOs.

3


1.3 Significance of the Study

1.3

Significance of the Study

Thus far, none of the REIT IPO studies have examined the earnings management
by REITs and their impact on REIT IPOs’ underpricing and after market performance. This study attempts to fill the gap by examining REIT underpricing using
the earnings management methodology of Teoh, Welch, and Wong (1998).
Employing the earnings management method, we empirically test whether REITs manage their earning in IPO year like companies in other industries. If REITs
were involved in earnings management, how would their post-listing financial performance be affected?

We find that in IPO year, REITs have high discretionary current accruals, which
they decline in the following years. The magnitude of discretionary current accruals
is higher in the hot market than in the cold market. We find that compared to
non-discretionary accrual, the discretionary components have stronger predictive
power over the change in earnings performance between IPO year and one year
after IPO.

1.4

Hypothesis Development

Studies show that IPO stocks have high abnormal initial returns. Most of them
attribute such abnormal returns to underpricing of these stocks. However, researchers report that earnings are abnormally high in IPO years. There is evidence
to suggest that IPO companies manage their earnings during IPO periods. Industry companies are opportunistic when planning for IPO (Teoh, Wong, and Rao

4


1.4 Hypothesis Development
(1998)). In this sense, the abnormal initial returns are not fully caused by stock
underpricing. Instead, investors are not informed of firms earnings in the financial
statement.
We develop four testable hypothesises to examine the relationships between earnings management and aftermarket performance of firms.
Hypothesis 1. Are REITs involved in earnings management during IPO periods?
Given the benefits of earnings management, REITs may exploit accrual accounting principle to inflate their earnings by taking advantage of their superior information. Even though, REITs are generally considered to be more transparent than
other companies, we cannot rule out such possibility.
Hypothesis 2. Do REITs manage their earnings more aggressively in the hot
market?
In the hot market, investors tend to be more enthusiastic about prospects of IPO
companies. There are more sentiment investors in the hot market. Issuing companies understand the situation and will manage their earnings more aggressively in
the hot market to take advantage of these investors.
Hypothesis 3. Do REITs that manage earnings more aggressively have poorer
earnings performance in the following years?
Earnings management is achieved by borrowing either from the past or the future
earnings, which is not sustainable. Companies aggressively managing their earnings
perform worse than their more conservative counterparts. Teoh, Welch, and Wong
(1998) found that aggressive companies performed poorly in the post-IPO periods.

5


1.5 Organization of the Study
Hypothesis 4. Do large REITs have economies of scale benefits?
One of the reasons why companies go public is to reap economies of scale benefits.
Large companies can reduce average costs of their products. They tend to have
more market power compared to smaller ones, and they have more favorable terms
when borrowing money from banks. Companies have more resources to expand
their business when they are listed.
With presence of economies of scale, should a company’s performance deteriorate
after IPO, we can speak with greater confidence that earnings management is the
cause.

1.5

Organization of the Study

The rest of the thesis is organized as follow. Chapter 2 reviews relevant literatures.
In this chapter, we first review two strands of literatures on IPO underpricing — information asymmetry theories and behavioral theories. Then we review researches
on earnings management during IPO periods for general industrial companies. After that, we review literature on economies of scale effects. We also review papers
on IPOs in REIT industry.
Chapter 3 describes various measurements for earnings management. We describe how Jones (1991) model and Modified Jones models are used to measure the
magnitude of earnings management. Next, we discuss three widely used models for
measuring economies of scale effects — the Translog Model, the Simple Quadratic
Model, and the Quadratic Semi-Log Model.
Chapter 4 presents empirical findings of the study. We test earnings management

6

1.5 Organization of the Study
in REIT IPOs. In this part, we also analyse earnings performance, discretionary
current accrual, explanatory power of discretionary current accruals, and potential
sources of earnings management of REIT IPOs. We also discuss empirical results
on the economies of scale using the three measuring models.
Chapter 5 concludes the study by summarizing some of the key findings, limitations of the study and future extensions to the current research are also discussed.

7


Chapter

2

Literature Review
2.1

IPO Underpricing

Going public is a major milestone in the life of a company. There are several
interesting issues that draws the attention of industry and academic. The high
initial return of initial public offering (IPO) corporations and the long-term after
market performance are two questions that have puzzled researchers for a long time.
The initial return is defined as the difference of the stock’s IPO offering price and
its first day closing price. High initial return is usually referred to as underpricing.
Underpricing and high abnormal initial return are used interchangeably in the
literature. After market performance is referred to as the stock performance after
IPO.
Logue (1973) and Ibbotson (1975) found that firms tend to underprice their

stocks in IPOs. According to Ritter and Welch (2002), the extent of abnormal
initial return are considerable high: averaging 18.8% from 1980 to 2001. The subperiod averages of abnormal returns are estimated at 7.4% from 1980 to 1989;

8


2.1 IPO Underpricing
11.2% from 1990 to 1994; 18.1% from 1995 to 1998; 65% from 1999 to 2000; and
14% in 2001.
Ritter (1991) showed that cumulative adjusted returns (CAR) for 1526 average
matching firms for the period 1975-84 is 29.13% lower than other comparable firms
for the 36 months after the offering date.
Given the significant amount of “money left on the table” (i.e. underpricing)
during IPOs periods, many theories emerge to explain this phenomenon. They fall
into two categories — information asymmetry and behavior theory. Information
asymmetry theories explain high initial return well, but they offer limited explanations on after market under-performance. The behavior theories work better in
explaining the declining after market performance.
The earnings management theory adopts a different approach that focuses on
financial performance of the issuing firms. Most of the theories including information asymmetry theories consider high initial return as “leaving money on the
table” by the original sponsoring companies. In contrary, the earnings management literature provides evidence that issuing firms take advantage of investors. It
can also explain the after market under-performance well.

In the following part of review, we review literature on the information asymmetry theories, the behavior theories, and the earnings management theory. After
that, we will review related studies on REIT IPOs.

9


2.1 IPO Underpricing

2.1.1

Information Asymmetry

Three parties: issuing company, underwriting bank, and investors, are involved in
an equity offering process. One party could have superior information than others. The issuing company knows more about its operational and financial status
than investors do. Similarly, investors know better about their demand for stocks
than the issuing companies do. Therefore, we face information asymmetry problem, when we try to price stocks. Different hypothesises have been independently
proposed by various theories to explain why IPO stock could have seemingly high
abnormal return in the IPO offer day.

Different assumptions on information asymmetry divide the theories into 3 categories. They are winner’s curse, information revelation, and signaling theory. The
winners’ curse theory is based on the assumption that institutional investors have
superior information than retail investors. The information revelation theory assumes that some investors know more about market demand than issuing firms
and investment banks. The signaling theory says that issuing firms know more
about their own operational performance and financial status, and good companies want investors to know them. We will review these three theories in details in
the following sections.

Winner’s Curse
Information asymmetry exists not only among the three different parties, but also
among the same party. Institutional investors and retail investors differ in terms
of accessibility to market information. Institutional investors have more resources

10


2.1 IPO Underpricing
and expertise in studying financial market than retail investors. They are better equipped with market intelligence to explore fundamental value of a company.
Institutional investors are usually considered as informed investors, and retail investors are considered to be uninformed ones.

Informed investors will bid for more shares in a firm with a good economic
fundamental, such that uninformed investors are like to be driven out (at least
partly) in the bidding exercise. At the same time, informed investors are also better
at avoiding buying under-performanced stocks. Retail investors are trapped in an
unfavorable situation which is known as “winner’s curse” by Rock (1986). Given
that uninformed investors are not capable of identifying “lemon” firms, they pay
higher than average market prices for stocks they buy. As a result, the uninformed
investors earn negative returns, and are driven out of market. In reality, this is
not strictly the case. Rock (1986) assumes that informed investors cannot absorb
all shares placed out in the market, including shares offered by good companies.
Therefore, the market is large enough to attract participation of retail investors.
Firms underprice their stocks to ensure that uninformed investors earn at least
non-negative returns, so as to attract them to the market.
However, as the information asymmetry between investors and issuing firms has
not been resolved, free-riders may exist to exploit the system by underpricing stocks
at a smaller margin. Beatty and Ritter (1986) argue that the free-rider problem
will not disrupt the issuing exercise. Investment banks will favor stocks underpricing by a right margin in order to secure their business and market share.

The Winner’s curse theory has several implications when applied to analyze

11


2.1 IPO Underpricing
under-pricing of IPO stocks. If information asymmetry is less severe between informed and uninformed investors, the extent of underprice is smaller. Michaely
and Shaw (1994) indicate that institutional investors largely avoid IPOs of master
limited partnerships (MLPs), because the income received from MLPs is classified
as unrelated business income, which leads to tax disadvantages. Investors participate in MLPs are mainly retail investors, and information asymmetry among them
is low. The paper shows that the regular IPO group has a mean return of 8.5%,
which is significant different from zero. Whereas, the IPO of MLP groups has a

mean initial-day return of -0.04%, which is not significantly different from zero.
The result is consistent with the winner’s curse theory.

Beatty and Ritter (1986) argue that there is positive relation between ex ante
uncertainties and expected underpricing of IPO stocks. They indicate that when
the ex ante uncertainty increases, the winner’s curse problem intensifies. Investors
will have higher probability of losing their money. Thus, a firm will leave more
money on the table (underprice more) to attract uninformed investors. A number of
empirical studies chooses various ex ante uncertainty proxies to test this hypothesis,
which include listed proceeds (Beatty and Ritter (1986)), gross proceeds (Beatty
and Ritter (1986)), firm age (Ritter (1984)), log sales (Ritter (1984)), etc. The
evidence support the winner’s curse theory.
We expect greater underpricing, when IPO firms facing greater ex ante uncertainty. Investment banks (underwriters) will lose market share, if they do not
underprice tacking into account ex ante uncertainty of financial performance of
IPO firms. Dunbar (2000) finds that investment banks will lose market share if
they do not price the IPO properly, i.e. underprice or overprice too much.

12


2.1 IPO Underpricing

Underpricing is costly. Issuers thus have incentives to narrow the information
gap and reduce underpricing. A reputable underwriter is a positive signal for the
quality of a firm. Carter and Manaster (1990) show that more prestigious investment banks are associated with less risky IPOs, because the prestigious investment
banks will cautiously choose to issue less risky ones to preserve their reputation.
For investment banks, reputation is the most important asset. There could be
endogenous problems, since only big firms could afford to hire those prestigious
banks. Firm size itself is negatively related to underpricing (Ritter (1984)). In the
early 1990s, the data show that more prestigious underwriters underwrite more

underpriced IPOs. However, Beatty and Ritter (1986) also show that the relation
between reputation of underwriter and underpricing of IPO stocks has changed
since 1980s.

Information Revelation Theories
Rock (1986) assumes that institutional investors are not only better informed than
retail investors, they are also better informed than investment banks and issuing
firms in some aspects. Institutional investors understand the market better, and
know more about market demand and price. Higher offer price is not in their best
interest, while lower price is. Without economic benefits, informed investors are
not likely to reveal positive market signal. Instead, they will disseminate false
negative signal and try to lower the offer price. At the same time, investment
banks’ commission fees and market share are based on their capability of setting
appropriate offer price. They have incentive to explore those informed investors’
information.

13


2.1 IPO Underpricing
Given that underwriters have discretionary power over IPO share allocation as
claimed Spatt and Srivastava (1991), book building can ensure informed investors
reveal their information. In the book building process, investment banks collect
investors’ bid prices. They allocate more underpriced IPO shares to the most
aggressive bidders, while allocate fewer or none of the shares to the conservative
ones. A large proportion of IPO share is allocated to the informed investors. There
is enough “money on the table” to give them incentives to bid aggressively on the
IPO process. As a result, high abnormal returns for IPOs in the initial days are
expected.
Issuing firms have incentives to leave more money on the table, if informed investors would reveal more positive information, which help push offer price higher.

Issuing firms benefit from the higher offer price. The more price revisions are made
in the book building process, more money will be left on the table, which is known
as partial adjustment by Benveniste and Spindt (1989)
Informed investors are mostly large institutional investors, who have constraint
dealings with major investment banks. In the framework of repeated game, informed either investors will reveal their information honestly, or be expelled by
major underwriters, which may cause them to lose more in the long-run.
Cornelli and Goldreich (2001) studied 39 equity issues that took place between
1995 and 1997. The issuing companies come from 20 different countries and from
different industries. Bidders come from 60 different countries throughout Europe,
North and South America, Asia, and Australia. All issues are globally place out by
a leading European investment bank with international presence. The 39 equity
issues consist of 23 IPOs and 16 seasoned equity offerings (SEOs). They found that
the investment bank awards more shares to bidders who reveal information through

14


2.1 IPO Underpricing
limit prices than to bidders who submit quantity bids without price limits. Bidders’
revision of their bids can be interpreted as providing new information over time,
and they receive more favorable treatment in share allocation. Bidders with limit
and step bids receive an extra 19 percent and 26 percent IPO shares allocation
respectively. Cornelli and Goldreich (2003) take a step further to explore how
informative is revealed in the order book. They found that information in bids,
which include a limit price by especially large and frequent bidders, have the most
significant effects on the issuing price. The evidence suggests that book building
is an effective way of obtaining informed investors’ information, and the result is
consistent with the results of Benveniste and Spindt (1989).

Signaling Theories

Among the three key parties in the issuing process, informed investors are not the
only party with superior information. Companies have better information on the
present value and risk of the companies concerned. Investors facing greater uncertainty will be hesitated to participate. Issuing firms have incentives to mitigate
the information asymmetry by signaling their quality. Underpricing is one of the
signaling methods. High-quality firms distinguish themselves from the crowd by
underpricing to the extent that low-quality firms cannot afford to mimic. “Leaving
a good taste in investors’ mouths” as argued by Ibbotson (1975) help firms perform better in next round of equity offerings – seasoned equity offerings (SEOs).
Jegadeesh, Weinstein, and Welch (1993) found that firms that underpriced IPO
stocks are more likely to go for SEO, and have bigger issuing size for the SEO.
However, the evidence was statistically weak.

15


2.1 IPO Underpricing
Michaely and Shaw (1994) pointed out that decisions on how much to underprice
and the decision to go fore SEO are not independent. When considering whether
to underprice, the issuing firm will take into account the possibility of re-entering
market for SEOs later. Thus, the decision on the amount offered to the public in
the SEO is endogenous and made simultaneously with the decision of what underpricing signal to be sent to the market during the IPO. Using a simultaneous
equation model they found no evidence to support the signaling theory. The results
indicate that the decision of how much to underprice is not significantly related to
the SEO decision and vice versa.

Signaling theory is not as robust as it is expected to be. Other signaling tools
include prestigious underwriter (Carter and Manaster (1990)) , and issuing smaller
portion of shares.The signaling theory needs empirical evidence to support the
claim that issuing firms do not have to leave so much money on the table.

2.1.2

Behavioral Theories

There are two major behavior theories in IPO underpricing – prospect theory and
investor sentiment theory. The prospect theory is based on the observation of
partial adjustment of IPO offer price. The issuers’ wealth usually increases after
IPO. If issuers are greedy by pushing the offer price too high, the offers may
fail. The issuers are likely to be conservative. They will trade off between loss in
underpricing and gain in stock price jumps.
The second behavioral theory is the investor sentiment theory. From time to
time, there are frenzy investors, who will buy whatever out in the market. These

16